Masterclass with Superinvestors

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Contributed by: Udai Cheema

I had pre-booked my copy and my excitement was justified as I found the contents of the book so enlightening that it took me just two days to blaze through the book.

Before I pick it up again to re-read and write a detailed book review for all of you, I would like to share my experience and learnings from the event organized by CFA society India at New Delhi on 25th Jan 2019 for the two wonderful authors of this book, Saurabh Basrar & Vishal Mittal.

Having read the book, my curiosity to meet the authors was understandable. Also, the thought of getting to know what according to them were the key elements that made these Super-Investor really ‘SUPER’ drew me to the event and boy was I in for a treat!

My journey began on the Shatabdi Express that leaves from Chandigarh in the afternoon for New Delhi. The best part about taking this wonderful train is that one can get a lot done on the way and that’s exactly what I did. I took this opportunity to pen down all the questions that were on my mind ever since I had read the book. Seeking answers I landed in New Delhi and took the ever so convenient airport express to the Hotel IBIS at Aerocity where this event was being held.

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I chanced upon a great opportunity to interact with the authors for a few minutes prior to the start of the event. The details about how they started their investment journey were quite inspiring and the openness with which they shared their experiences and learnings was truly humbling.

They have been investing in the markets since the early 2000s and started Altais Investment Advisors in 2007. In December 2018, they published the book Masterclass with Super-Investors which has been quite a seller from what I gather from the investor community across India. It is a collection of some nicely compiled interviews with some of the ‘Super’/ ‘Highly successful’ investors in India who have created a huge amount of wealth for themselves over the last two to three decades.

Here are some of the key learnings and highlights from the event:

1. Every new investor comes to the market thinking on the lines of value investing and with a dream of getting rich the easy/quicker way but the markets tend to teach the newbies some painful lessons about reality.

  •  Bottom line: Active investing isn’t nearly as easy as it looks.

2. Some mind-boggling questions that make the task difficult include;

  • Is your idea a good idea?
  • How much capital to allocate?
  • What if it didn’t do anything for the time you held it?
  • What if it delivered but you had already sold by then?

and so on…….

3. The most important thing for an investor is to understand ‘his own temperament and goals’. This insight into one’s own behaviour is essential for stock market success.

  • In essence, one cannot become Warren Buffet or Rakesh Jhunjhunwala because they possess certain temperament and style of investing which is unique to them. The stock picks can be copied but not the knowledge and the temperament, this alone leads to a wide variation in the returns obtained by these super-investors and the ‘coattail’ investors.
  • Rather than trying to copy someone else’s investment strategy, try to backtest and solidify on the strategies which have worked for you in the market.
  • Independence of thought, Discipline, Courage and Delayed gratification ( for both, consumption and return on investment) are some of the keys to becoming a level headed investor.

4. Many investors jump onto the bandwagon during the market peaks but unfortunately, they are driven out of the markets in the first down cycle. In order to avoid that one needs to figure out a few things before deciding to plunge into full time investing.

  • Do you even have a temperament for active investing? If not then go the low churn, long term investing way.
  • What is your financial situation in terms of the size of your savings, alternate cash flow streams?
  • Are you willing to commit a substantial amount of your net worth to equities? The base with which you begin can make a lot of difference to your performance.
  • What do you want from the market? Is it simply another source of income or you wish to make serious wealth from the markets.
  • How much effort and time are you willing to commit to investing?  Markets, in general, have given 12-13% CAGR over time, so if you are happy with that return then there is no point going full time into investing. Simply buying an Index fund for the long term will do the trick. Rather a better way to look at it in terms of ‘Return of Time Invested’.

5. Develop your own investment framework like some of the Super-investors have devised for looking at companies. For example;

  • Ramdeo Aggarwal: QGLP framework i.e Quality of management, Growth visibility, Longevity of business, Price and valuation.
  • Anil Goel: KCPLTD framework i.e Knowledge, Conviction, Patience, Luck and Timely Deployment of funds.
  • Hiren Ved: GARP framework i.e Growth At Reasonable Price.
  • Vijay Kedia: SMILE framework i.e Small in size, Medium in experience, Large in aspirations, Extra large in market potential.

According to the authors, there are five components to look at while analysing a company;

  • Growth
  • Return on Capital
  • Free cash flow
  • Capital Allocation
  • Valuation

All five parameters have to be on the rise in order to make a multi-bagger.

  • Growth without ROE and cash flow will be short-lived.
  • High ROE and cash flows might help sustain high P/Es but won’t give high returns.
  • Good capital allocation will determine the sustainability of growth and valuations.

6.  FOCUS is key to successful investing. Rather than becoming a jack of all trades, an investor should try to master a style of investing and stick with it.

  • All the super-investors profiled in the book practice different styles of investing. They all are unique but one thing that they share in common is an extreme focus on their time tested methodologies and continue to refine them rather than trying everything that’s out there.
  • Understanding one’s investments is of the utmost importance, otherwise, decision paralysis is likely when the going gets tough.
  • Focus on the stock you wish to buy and wait for it to get cheap. Don’t rush to buy an alternative just because the one you like is expensive at the moment.

7. Develop good habits such as reading, maintaining an investment journal, being thorough with your analysis and reflecting on your past stock picks to figure out what has worked for you, what hasn’t and why.

8. To be right in turnarounds and cyclicals needs special insight. Considering the probability of success is low, one should stay clear until you have a good understanding of how to play them.

9. Risk Management is important. One needs to assess risk from all the angles which include market risk, portfolio risk and stock risk.

  • All super-investors have developed their own risk management strategies and every investor must strive to do the same.

10. Understand that intrinsic value is a moving concept. If the management executes and the business is in an up cycle, one should not be afraid to average up in a good quality growth story.

11. All the super-investors made their big money in a few stocks which shows the importance of capital allocation in a portfolio. It’s not about how many stocks you get right rather it’s about how much money you make when you got it right.

12. When to sell?

  • Fixed notion of intrinsic value, tendency to capture profits in a bull market and the psychological trauma of a prolonged bear market can lead an investor to book profits early.
  • Some of the reasons for late selling could be not timing the commodity cycle accurately, falling in love with your stocks even if the fundamentals are dwindling.
  • So one must develop some structure around selling, a strategy of sorts. An investor needs to see a market cycle or two to realise the importance of this as some things need to be experienced in order to imbibe their true essence. Simply reading in a book can’t replicate the experience of a 50% drawdown at a portfolio level. You need to experience it to believe it.
  • Stock price going way beyond fundamentals or deterioration of fundamentals can be some of the criteria that an investor can use to build an effective sell strategy.
  • Forgo the delusion that you can find the top or the bottom of a stock. Hence, either you will have to sell on the way up or on the way down. If it’s on the way up then it can be done slowly with each incremental rise but if your strategy is to sell on the way down then it has to be relentless once the threshold is breached.

13. Make the ‘study of the market cycles your top priority‘. Sooner you understand the power of the market cycles, faster you will realise that markets are supreme and some of the return you are making in a bull market is more due to luck than skill.

  • An uptick in the market cycle can make ugly ducklings look like swans and a downturn in the market cycle tends to throw the baby with the bath water.
  • A broader sense of where we stand in the market cycle is crucial. This might help an investor safeguard his portfolio to some extent for an eventual down cycle and maybe come into some cash in the portfolio which can be deployed in the bear market. The reason for highlighting a few words here is that doing so can be challenging and needs experience but one should try.
  • Going through a few market cycles is imperative in the making of a seasoned investor.

14.  Reflecting on past decisions and their outcomes have been a crucial factor in the success of all these super-investors.

15. If you have not been successful so far, don’t give up. It only takes one market cycle for someone to be successful. The problem starts when investors start becoming arrogant after making some money and stop differentiating between luck and skill.

16. Don’t regret. Markets are a place of regrets. If the stock goes down, you regret why you bought it. If the stock goes up, you regret why you didn’t buy more. If you sell early you regret, if you sell late you regret. So your peace of mind is in your hands, if you wish to regret then market gives you plenty of reasons to do so.

17. Believe in continuous learning.

  • Learn to differentiate between facts and opinions. Keep in mind that there will be varied opinions about the same facts and that’s what makes the markets so dynamic.
  • Have strong opinions held weakly. Allow yourself to change your strongly held opinions if facts change.

18. Take responsibility for your mistakes. There is no point blaming the markets or anybody else for your losses or failure of diligence.

19. An investor has to be an eternal optimist. You cant bet on the bright future of your companies if you are not optimistic about the future itself.

  • According to most of the super-investors, whatever wealth has been created by equities in India in the last twenty years will be dwarfed by what will be created in the next twenty years. – That’s optimism for you.

20. Respect the entrepreneurs. We as investors should never forget that we are simply riding on the shoulders of these super-humans who build great companies from the ground up. It is extremely difficult to scale up companies and they deserve all the credit for giving it a shot.

Conclusion:

It is one thing to go about gathering knowledge for oneself and its another to share it with others. The Super-investors along with Vishal and Saurabh have done the latter with their book ‘Masterclass with Super-investors’. This seminar provided a great opportunity to know the people behind this mammoth effort.

Having read the book myself, I would highly recommend it to anybody who wishes to make a success out of themselves in the markets as the wisdom shared by the Super-Investors is priceless and the way Saurabh and Vishal have compiled these interviews is nothing short of fantastic.

A special shout out to Jitendra Chawla and his team at CFA Society India for organising such informative events.

Important Disclaimer: The contents of this article must not be construed as direct quotes from any of the speakers. The ideas/opinions mentioned here should not be taken as investment advice of any sort as they are for educational and informational purposes only. This article has been compiled exclusively from the author’s notes penned down at the event and contains significant emphasis and paraphrasing on the part of the author. The following content must be read keeping this in mind at all times.

-UC

 

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50 years of Z-Score…

Written by: Chetan Shah, CFA, Secretary CFA Society India and Partner 3 Jewels Investing

One of the scoring systems for predicting bankruptcy of a manufacturing company, Z-Score has not only survived for 50 years but has been thriving. On the Bloomberg terminals there are around 10,000 daily visits! So, what makes this model so popular? In Dr. Edward I. Altman’s words firstly, it is simple to explain. Secondly, it is still accurate in predicting bankruptcy and defaults fairly in advance. Thirdly, it is available for free. No royalties from market participants or other users!

Z-Score measures ratios like liquidity, solvency, profitability, capitalization and viability of non-finance / manufacturing companies and combines them to give the overall number. Depending on where this total is the companies are categorized into “Safe”, “Grey” and “Distress” zones. Kindly, refer to the equation below.

where WC = Working Capital, TA = Total Assets, RE = Retained Earnings, MCap = Market value of Equity

Companies with Z scores greater than 2.99 are in “Safe” zone, Score between 1.8 and 2.99 in “Grey” zone and those below 1.8 in “Distress” zone.

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In the initial stages, Altman Z-score was found to be 72% accurate in predicting bankruptcy two years preceding the event including Type 2 errors (classifying the company as bankrupt even when it’s not going to be in future) of 6%. However, the professor modestly says that the model may not be as relevant today as it was earlier. This is on account of credit risk migration, increase in Type 2 errors, greater use of leverage, impact of high yield bonds, global competition, more and larger bankruptcies, near extinction of AAA firms. During 2016 there were only two AAA rated firms in the US, and they were Microsoft and Johnson & Johnson.

Some variants of this model were created later like the one for private firms and another for the non-finance industrial firms in Emerging Markets (called Z-Score Prime in 1995 for Latin America and 2010 for China). However, little published research is available for countries like India. Likewise, we still lack proper models for predicting probability of default or loss on debt of banking & finance companies or those of sovereigns.

Both the Z-Score and the bond equivalent ratings of the companies keep changing over the period. What was surprising is that the ratings provided by the rating agencies were higher than could have been provided by the simple Z-Scores. Take the example of GM’s (General Motors) paper during global financial crisis during 2008. Its bonds were rated “B-“ two years before its default rating even when its Z-Score was below 1.8 or in the “distress zone”. Though the company emerged stronger through bankruptcy process and had maintained rating of “B” between 2010 and 2014 its Z-score had been below 1.80.

The high yield market has grown to $1.67trillion (tn) in the US and $2.8tn globally. Of this 15-20% of the bond are newly issued CCC bonds, which are very close to default, yet the market is thriving. This has been possible as investors are compensated for assuming higher risks. Hence there is a trade-off between default rates and recovery rates. Depending on the stage of the economic cycle, the recovery rates can vary from 40 cents on a dollar to 25 cents. On an average 20 companies with size of $1bn and above file for bankruptcy protection in the US. In good times (from bankruptcy professional’s point of view) 70-80 companies file for the same.

So, is the benign credit cycle over? Based on default rates, default forecasts, recovery rates, yields, YTM & OAS spreads between high yield markets and treasury notes, liquidity, length of credit cycle, Dr. Altman says “No”.  What worries him though is surge in the size of debt both in absolute terms and as a percent of GDP and across sectors like non-financial corporations, government and households. Besides these the other big risk is politics on global trades.

-CGS

PS: For the presentation please click on 50 Years of Z-Score

 

 

 

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Market Outlook – Feb 2019

By: Navneet Munot, CFA, CIO, SBI Funds Management Pvt Ltd and Chairman, CFA Society India, IAIP

Union budget for FY 2019-20 was staged against the backdrop of compulsions of pre-election spending but a challenging revenue situation, primarily emanating from the shortfall in GST collection. Deflation in food prices and mounting agriculture debt have highlighted the accentuating farm distress. Further, the thrust on infrastructure spending over the last few years (particularly on road, railways, housing, urban development) had just started to bear some result. The capacity utilization for some of the sectors had started to improve and it appeared that private sector was mulling capex on the expectation of continued order inflow from the government and growth improvement in the economy. These developments further complicated the difficult choice between fiscal rectitude and a pause to enable the process of stimulating the economy.

Against this backdrop, the government had eventually sided with marginal glide path on fiscal consolidation. Fiscal slippage in 2018-19 was limited to 10bps and revised deficit estimate is pegged at 3.4% of GDP. As per the revised FY19 numbers, the fiscal slippage gets primarily explained by the higher expenditure (Rs. 200 billion of allocation towards income support for small and marginal farmers).

The shortfall in GST, telecom receipts, non-financial PSU’s dividend is expected to be offset by higher direct taxes. Prima-facie, it appears that government also aims to utilize the undistributed compensation cess fund in FY19 and ask for Rs. 200-300 billion of interim dividend from the RBI.

Fiscal deficit for FY20 has been kept at 3.4% of GDP and thus frayed from the Fiscal Responsibility and Budgetary Management (FRBM) Framework which mandates the government to reduce the fiscal deficit by at least 0.1% of GDP every year till the deficit reaches 3% of GDP. In any case, another FRBM target of reducing central government debt to 40% of GDP by FY25 could also be challenging as the recapitalization of public sector banks and increasing issuances of government guaranteed/serviced debt are adding to the debt burden.

Tax assumptions for FY-20 (14.8% growth and 12.1% as percentage of GDP) are a bit on the optimistic side but not completely out of line if one assumes better enforcement of GST compliance post the general election. Dividend from RBI has been scaled up. In the current year, RBI has built its balance-sheet with G-sec as opposed to foreign securities and has stayed in Net Repo mode through most part of the year. Both the factors will ensure higher interest income. Disinvestment targets have been scaled up marginally (by Rs. 100 billion). It can be achieved if some of the long pending strategic asset sale were to materialize. A large part of the expenditure side (salaries, pensions, defense, and interest payment) is sticky. Hence, it is imperative that tax-to-GDP ratio increase substantially to enable higher spending on social and physical infrastructure.

Some relief could come to the fiscal if a windfall gain is obtained from RBI’s excess capital being transferred to the government. A committee with a 3-month timeframe (Jan-Mar) has been set up to evaluate this issue. The base case we expect at this stage is that the committee may direct the central bank to suspend the build-up of contingency fund for several years and transfer the entire surplus to the government each year (just as done during the year FY14-FY16).

As expected, the budget kept its focus on rural, small and medium enterprises and middle-class households. While this is an interim budget and the actual realization of the visions (such as the changes in direct taxes in favour of the middle-class) will have to wait till the roll-out of the full budget post the general election, it does set a narrative. Some of the rural oriented schemes such as PM Kissan Samman Nidhi and Mega pension scheme are expected to be rolled out in FY19 itself and have seen the provision in FY19 revised estimates figure. The scale of the programs was at the lower end of market expectations (market feared a fiscal stimulus to the tune of Rs. 2-3 trillion) enabling the government to stay close to fiscal targets. These measures entail an income stimulus of ~0.5% of GDP primarily for the low-income strata but if the government were to go stricter on tax compliance (both income tax and GST), a parallel amount could be ploughed back from relatively higher income class.

The earlier years of the current government were focused on addressing the bottle-necks of growth. Consequently, we saw the taxation reforms, banking sector reform, real-estate reforms, e-auction of natural resources, reduced time-lines in obtaining the business clearances, bringing the parallel economy into the mainstream, a drive towards implementation of Aadhar and financial inclusion. These reforms yielded visible gains in terms of formalization, digitization, financial inclusion and lower inflation. Yet, for a variety of reasons, the reforms are yet to translate into a higher income gains. The rising inequality and the unique nature of a large un-organized sector in the Indian economy make it imperative for a government to not only worry about the overall growth and reforms but the distributional aspects of growth i.e. a more equitable growth.

So far, India has already seen its own version of Universal Basic Income with the implementation of MGNREGA, free LPG, Free LED, Free Toilet, Free debit and credit card, Free health Insurance, cheaper housing, various interest subventions, benefits for girl child and so forth. Guaranteed income for small and marginal farmers and pension for workers in unorganized sector have got added today. Robust social security net is a must for leveraging demographic dividend and creating a sustainable, equitable growth to preserve our democratic and liberal society. JAM trinity (Financial inclusion, Aadhar and mobility) should be made best use of to prevent leakages in such schemes. Effective execution will be the key.

The gross borrowing target for FY20 had been scaled up to Rs. 7.1 trillion, even as the net borrowing was kept unchanged at Rs. 4.2 trillion (net of buy-backs). Further, the borrowing for FY19 has also been revised up by Rs. 360 billion to Rs. 5.7 trillion (borrowing calendar penciled Rs. 5.35 trillion). Consequently, 10-year bond yield jumped up by 15bps post the budget release. The bond market is faced with a mix of push and pull factors. While the extremely muted headline inflation, stable external account dynamics, dovish bias in key global central banks and continued OMOs by RBI augur well for the Indian debt market, the high gross market borrowing and the large emphasis on off-budget borrowing requirement would prevent a material rally in the yields. With the fiscal stimulus being limited, we continue to build in the probability of a rate cut by RBI in February.

The relatively sticky revenue and expenditure status at the center is leading the government to look for off balance sheet sources of funding as meeting the FRBM targets is becoming difficult. The importance of Internal and Extra Budgetary Resources (IEBR) of the Public Sector Undertakings is increasing as the budgetary support is lowered for them. In turn, there has been an increased supply of bonds from the Public Sector entities. And this is reflected in elevated corporate spreads.

From equity market perspective, budget would be seen as a positive event given the continued focus on income enhancing measures. Structural reforms undertaken over the last few years should start yielding returns over a medium term. As the event is behind us, market’s focus will shift back to global cues, political developments and earnings trajectory. Improved earnings prospects with correction in valuation should lead to a double-digit return in equities. However, brace for an extremely high volatility in the near term.

-NM

 

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Executive Panel: India-Economy and Markets 2019

Moderator: Nikunj Dalmia, Managing Editor, ET NOW

Written by: Ishwar Chidambaram, CFA, FRM, CAIA

Delegates at the Ninth India Investment Conference (IIC19) 2019 had access to a distinguished panel. The subject was the outlook for Indian economy and Markets in 2019. The speakers included Navneet Munot, CFA, CIO, SBI Funds Management Pvt. Ltd., Milind Sarwate. Founder and CEO, Increate Value Advisors LLP, Sunil Singhania, CFA, Founder, Abakkus Asset Management, LLP, Ridham Desai, Managing Director, Head of India Research, and Equity Strategist for India at Morgan Stanley, Research Division, and Sajid Chinoy, Economist (Asia), JP Morgan. The moderator was Nikunj Dalmia, Managing Editor, ET Now, who enlivened the discussion by bringing the best out of the panelists.

The discussion began on a lighthearted note, but quickly took on serious tones as the panelists spoke about the year gone by. There was unanimous consensus that 2018 was a bad year for most asset classes (except gold), which have all generated negative returns.

Sunil opined that investors must remain optimistic and as long as India keeps growing the returns will follow. He said that the next two years will be the period when Value stocks outperform. Mutual funds are still in a nascent phase in India and are under-invested in the firms that will be future leaders of the markets. On themes for the next 1 to 3 years, he is bullish on Discretionary Consumption, and Beverages are his favorite sector. He is also bullish on utilities which are expected to return 15% annually.

Milind suggested that the rural sector is leading urban sector in consumption. News flows will reach a crescendo in the election year. On sectors, he is not very bullish on Pharma as it is not a great consumer play. In 2019, he expects the following factors to attract investors to consumer stocks- namely they are defensive, rural consumer demand will peak and digital revolution, which has ensured that the cost of creating a new brand has fallen sharply. He is bullish on firms like HUL, Dabur and smaller FMCG firms and retail plays. He expects proximity to the consumer to be important going forward.

Ridham reminded the audience that markets have long cycles. Legendary investor Howard Marks made only 6 active calls in 50 years! In India’s case, there were shocks to the system like demonetization and GST. In 2018, India witnessed the longest and deepest earnings draw-down in our nation’s history. He is sure there will be another panic in the stock markets, but feels that we are in an up-cycle. Growth will be the source of market returns. Elections are only a short term factor. Specifically, he emphasized the importance of Growth At Reasonable Price (GARP) strategy, saying that it is not good to overpay for growth. He does not prefer the term “Value”, as people often confuse it for “Multiples”. He prefers GARP.

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Sajid feels that crude prices explain India’s growth very well. Right now we are witnessing a positive terms of trade impulse from crude. The monetary conditions index is at a 2-year low. Policy reforms like asset reconstruction, IBC, etc. are starting to bear fruit. He is however apprehensive that monetary, fiscal and regulatory easing combined will push India over the edge, which could prove dangerous in 2019. He is also worried about the increased indebtedness of the Indian states, whose deficit is bloated. The underlying current account deficit has also worsened. He asserted that there is no fiscal space for populism and that some amount of rupee depreciation is a good thing.

Navneet said that with the fall in crude prices, India’s macroeconomic situation is better in 2019. There has been a tight monetary policy in terms of real rates. As GST compliance increases, fiscal situation will improve. Earnings have been below nominal GDP growth since 5-6 years. He expects decent returns over the next year, but markets will be very volatile. He prefers multi-cap funds, and feels that India is a stock picker’s paradise. There are many sectors where the largest companies are mid-caps or small-caps, and therefore have tremendous potential. Companies that are small and agile should trade at a premium versus large and slow companies. Corporates have deleveraged their balance sheets. He prefers Capital Goods, Engineering and Construction.

  • IC
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Behavioural Biases and Pitfalls: Stories on How Investors Go Astray and How to Overcome Them

Speaker: Morgan Housel, Partner, Collaborative Fund

Moderator: Kalpen Parekh, President, DSP Investment Managers, Pvt. Ltd.

Written by: Ishwar Chidambaram, CFA, FRM, CAIA

Morgan Housel- Partner, Collaborative Fund- gave an amazing presentation on behavioural biases and pitfalls faced by ordinary investors. This was the most eagerly anticipated session of the conference and it lived up to its billing. Morgan began by asserting that we all have vastly different experiences as investors.  He gave the example of 2 investors in the US, one of whom (“Grace”) was from humble background but earned millions through successful investing. The other (“Richard”) enjoyed a privileged upbringing but was forced to declare bankruptcy. Thus one can conclude that investing is not about what you know, rather it is about how you behave!

Morgan’s presentation revolved around 5 stories which reinforced his central theme:

Story 1: Nuclear Energy and Investing- Austrian citizens chose not to turn on a US $ 1 Billion nuclear power plant due to safety considerations. This was despite the fact that other nations like US, UK, Japan, etc. were all using nuclear power safely. Thus risk is not universally perceived the same way by all investors. Morgan gave the additional example of US and Australia. He said that Australia has had no recession in past 27 years, while US has witnessed 3 recession in the same period. Thus these two nations hold diametrically opposite views on the risk of recession- while US tends to be paranoid about recession, Australia tends to be complacent about the same. Similarly, individual investors’ willingness to bear risk depends on their personal history. As Daniel Kahneman points out- we explain the past with ease, but we are terrible at predicting the future. There are 3 ways to overcome this:

  1. Talk to as many people as you can- This helps to broaden one’s horizons
  2. Talk to people you disagree with- This helps to avoid confirmation bias
  3. Talk to people in different emotional states- especially important for financial advisers to regard clients without emotion

Story 2: War on Cancer- Today cancer rates are falling as the war on cancer has been effective at saving lives. We may be unable to cure cancer completely, but we can prevent cancer by modifying diet, lifestyle, etc. However, it is very difficult to raise money for cancer prevention (as opposed to cancer research). This is despite the fact that the impact of cancer prevention is greater than that of cancer research, but the former is just not very intellectually stimulating. The same applies to investing, wherein simple rules for investing are not followed by most people, who are looking for complex theories. Morgan compared the desk of legendary investor Warren Buffett with that of a trader from Lehman Brothers (shortly before bankruptcy). The former desk is simple and clutter-free, while the latter appears chaotic and disorganized. Morgan also pointed out that Warren Buffett’s investment firm Berkshire Hathaway has outperformed Private Equity funds by 5.1% on average. This is largely because the latter charges a 2 and 20 fee structure, while Berkshire does not charge any fees. This accounts for at least 4% out of Berkshire’s 5.1% annual out-performance. Morgan revealed that the father of Modern Portfolio Theory, Harry Markowitz- who pioneered the use of complex concepts like Efficient Frontier- himself used a simple 50:50 rule to split his investments among stocks and bonds! Morgan concluded by asserting that the goal of investing is not to minimize boredom, it is to maximize returns! If you want clients to stick around, then do things simply.

Story 3: Development of Babies’ Brains- The numbers of synaptic connections formed among neurons in an infant’s brain are amazing. These reach a peak by the age of 2 years, and keep declining steadily thereafter. A lot of synaptic connections in new-borns is actually haywire. Babies can actually hear colours and smell sounds! They get smarter by getting rid of the chaos in their brains. This analogy can be extended to investing. Most investors buy out of greed near market peaks and sell out of fear near market bottoms, repeating this cycle until they are broke! As Eisenhower remarked, “The great leader, the genius in leadership, is the man who can do the average thing when everybody else is going crazy.” This applies to successful investing.

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Story 4: Running- Archibald Hill was an English physiologist who attempted to answer the question “How fast can we run?”. He came up with exotic formulae to predict how fast a human being can run. In 1922, he was even awarded the Nobel Prize in Medicine for his efforts. The irony was that although his formulae were very accurate in the laboratory, they were of no practical significance on the racetrack. Thus they were of no use to predict future winners of actual races. Mr. Hill responded to his critics by saying that “We don’t do it because it’s useful, we do it because it’s amusing!” Mr. Hill and his team failed to account for the fact that how fast we can run is not just a function of bodies and muscle power, but also of psychology. Contestants in races get anxious, nervous, hyper-focused. This applies to predicting the financial markets as well. Every year since 2009, various financial publications have been screaming themselves hoarse saying “The easy money has been made!”. This has happened every year for the past 9 years, yet the bull run in stock markets has soldiered on. This is mainly because share prices are a function of 3 factors-

  • Dividend Yield – This is easy to calculate
  • Earnings Growth- This can be found
  • Change in Valuations- This is impossible to know as it captures people’s sentiments

This is where the Margin Of Safety comes in. As Ben Graham said: The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. Thus, while margin of safety gives an investor room for errors in forecasting, it does not imply conservatism.

Story 5: Wright Brothers and Investing- The invention of flight is today universally recognized as one of the most important developments of the 20th Century. However, the remarkable story of the Wright brothers quest to build a flying machine was not given any importance by the news media at the time. In fact, for nearly 2 years nobody paid any attention to this revolution in the making, except the Dayton Herald, which covered the story out of sympathy! The Wright brothers mastered the art of turning and landing the aircraft, thus demonstrating creativity and engineering ability, and ultimately pioneered the development of modern aviation. This story shows that important events which shape the future of humanity are often overlooked by news media.

The lesson from all the above stories is that stocks become less risky the longer one holds them (more than 10 years). Ultimately it is worth bearing in mind that people don’t get what they want or expect; they get what they deserve.

  • IC
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The Wisdom of Finance- Mihir Desai in Conversation with Paul Smith, CFA

Speaker: Mihir Desai, Mizuho Financial Group Professor of Finance, Harvard Business School; Professor of Law, Harvard Law School

Paul Smith, CFA, President and CEO, CFA Institute

Written by: Vivek Rathi, CFA

Prof. Desai tried to explain how finance is related to Humanity. His book “The Wisdom of Finance: Discovering Humanity in the World of Risk and Return” tries to connect two worlds which one thinks are not connected. He started by a quote from Wallace Stern “Money is kind of Poetry”  and followed it with a number of Pictures from history, each trying to communicate something important in contemporary world.

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Few key takeaways from his session:

  • Stories should be used to understand Finance
  • The world is random and not structured, there is randomness everywhere. Good part is, this randomness can be managed
  • Investors/managers generally face Principal-Agent problem
  • It is really hard to become principle
  • We do not punish people who fail
  • The gap between Finance and Humans is a real loss
  • Optimistic about India but expectations have to be rational
  • Indian companies should focus on Corporate Governance
  • Indian companies spend too much time on analyzing Policy makers/actions, instead corporates should focus on Innovation
  • VR

 

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Decision Making Under Uncertainty- Less Is More

Speaker: Gerd Gigerenzer, Director, Harding Center for Risk Literacy, Max Planck Institute for Human Development

Moderator: Madhu Veeraraghavan, Director and T.A. Pai Chair Professor of Finance, T.A. Pai Management Institute (TAPMI)

Written by: Chetan Shah, CFA, Director and Secretary, CFA Society India (IAIP), and Partner, 3 Jewels Investing

Most of the activities or events in the real world do not need complex formulae or algorithms to deal with them successfully. Take the example of Fly ball or cricket ball. In order to catch the ball, one can build in complex equations taking into consideration the angle of trajectory from the ground, force it has been hit with the bat, acceleration and later deceleration, and finally the spot where it will land. If the player were to do all those calculations in fraction of seconds will he be successful? Nope. Instead he is trained to run behind the ball keeping the angle of gaze constant, until the ball lands up in his hands.

Take another example of using simple heuristics. Chesley Burnet Sullenberger III (Sully) is a well known airline captain who landed US Airways Flight 1549 on the Hudson River off Manhattan after both the engines shut off as the plane was being hit by a flock of Canadian Geese shortly after take-off. All the 155 passengers on board survived. After the trials, the National Transportation Safety Board ruled that Sully made a correct decision in landing the plane on the river instead of attempting to return back to LaGuardia airport. Simulations performed at the Airbus Training Center Europe in Toulouse showed that the flight could have made it back to the airport had that maneuver begun immediately after the bird strike. However, such scenarios both neglected the time necessary for the pilots to understand and assess the situation, and risked the possibility of a crash within a densely populated area.

 

In both the above examples the intuitions of experts and the simple rules they followed helped them take faster and better decision. Such simple rules or heuristics are often been overlooked by the people. There are three widespread misconceptions about them viz. heuristics are always second-best to optimization based decision models, heuristics are unconscious and error prone, and complex problems require complex solutions. That happens because of failure to distinguish between “risk” and “uncertainty” and responses to deal with them. Professor Gerd Gigerenzer provided valuable insights in this area in a simple and humorous way.

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The four key messages from Gerd were (1) “risk” is not “uncertainty”. This distinction is still not very well understood & appreciated by many academicians. When we talk about risks, perfect knowledge of the future states of the world, their consequences and probabilities are available. Whereas under uncertainty all the future states, consequences and probabilities cannot be foreseen. Hence the best decision under “risk” may not be the best decision under “uncertainty”. (2) For taking rational decision making under uncertainty, simple heuristics are helpful as they reduce error compared to complex models which over-fit the past data. To illustrate the same consider the last year’s data on London’s daily temperatures or levels of any financial market index. Professor showed curves fitting the past data drawn with polynomial equations having degrees ranging from 1 to 12 degrees. Which one of these fits this data better? Naturally, the one with more degrees. However, when it came to predicting future temperatures or levels that was not true. The one with 3 (and up to 7) degrees predicted better than the higher degree polynomials. Likewise the one with only one degree showed higher variance. Hence the phrase from Einstein “make it simple but not too simple”. One degree has high bias + moderate variance. Third degree polynomial too has high bias but low variance. Higher degree polynomials like 12 degrees lead to low bias but very high variance in predictions. So in the field of predictions under uncertainty, you need to scale things down. (3) Are Finance Theories useful? We need new financial models, which are simple and have better predictability. Optimization models used to manage risk only create illusions of safety. (4) Lastly, less is more. Simple heuristics decision model can be more effective than complex optimization models. For example, the Fast & Frugal Tree for assessing bank vulnerability and comprising of only few key variables like (a) leverage ratio (<4.1%?), (b) market-based capital ratio (<16.8%),  (c) Loan to deposit ratio (> 1.4%) is more likely to succeed. This is because (i) they are simple to explain to key stakeholders like management and investors and easier to monitor, (ii) the correct combination of indicators can be less prone to gaming by the industry and (iii) banks can be spared with all complex stress tests. Hence simple effective rules are better.

  • CGS

 

 

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